Investing Fundamentals: Why should you invest?
This article is the first part of a series for investors who have just begun their journey in the professional world.
We are going to talk about 3 key things in this series:
1. The magic of compounding
2. The need for diversification
3. How to invest in equity
In part-I, we will cover only Inflation and the power of compounding.
Inflation: Eating away at our money
Inflation is the phenomenon of rising prices as the years go by. What cost you Rs X a few years ago now costs more than X. That means that the purchasing power of money keeps reducing.How do you quantify it?
Let's take an example of a bottle of coke. A 200mL bottle used to cost Rs
5 in 2005, now it costs Rs 18. That's a 2.5X increase in 15 years.
Aside from our staple drink of coke, we buy a lot of other food, clothing, and basic essentials, and pay rent electricity, fuel, and everything else. Everything gets more expensive with the time.
Now the reason for price rise are many, but all else equal, with time prices rise. When we measure it on a year-on-year basis we get inflation for that year. Below is a chart of how it has varied over the last 2
decades (2000-2020).
The measure used here is CPI inflation, which tells you
how much dearer a fixed set of goods & services cost over a year on
year basis. It is an approximate measure of our cost of living, which increased at the rate of CPI inflation for that year. For example, if your cost of
living was Rs 100 for 2020 (oh how I wish it was), and inflation was 6%
for 2020-2021, then your cost of living for 2021 is Rs 106.
Using this average, we can project an approximate cost of living in the future. No one knows exactly what the rate of inflation will be, but we
can project it for different rates and get a range.
The graph above shows that our cost of living will become anywhere
between 2.7 and 10.8 times our current cost, if inflation was between 4%
and 10% every year.
Compounding: A case study
Consider 2 friends Ajay and Abhay. Both are 30 and want to retire by 55.
So they have 25 years to build wealth. We have assumed a rate of return of
12% on average on their portfolio.
Ajay decides to invest Rs 1 Lac every year for 10 years towards his
retirement.
Abhay starts investing along with Ajay, but after 5 years decides to pause his SIPs. He wants to enjoy life for a while before taking on retirement
responsibilities.
After the 10th year, Abhay starts reinvesting 1 lac per year again till the
25th year.
Would you like to know their totals at the time of retirement? 
At the end of the day, Ajay ended up building a corpus of 97L by investing the only 10L. Abhay had to invest 20L and still got a corpus of only 83L at the end of 25 years.
Compounding works its magic over time and it pays to start early.
The destructive power of inflation
Now that Ajay (or Abhay, whoever you choose to be) has retired, 25 years in the future he has a retirement corpus of about 97L. But we have not considered inflation yet. How much is that 97L really worth in today's money?
If we look at the expenses graph again and assume that inflation was at 5%,
his 1 rupee worth of goods is now costing him 3.4 rupees. That means his purchasing power has gone down by 1/3.4 times.
Essentially, his 97L (in the future) is worth about Rs 28L in today's
money.
Had Ajay kept his investment only in a provident fund (giving ~8% return), he
would have ended up with only 46L after 25 years, which is worth 13L in
today's money.
An extra 4% every year can make a huge difference over time. As inflation
keeps eating away at our money, it is essential to get a higher return on your
investment.
The next question is how to invest to get higher returns??
That will be answered in Part - II.
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Update: Click here to go to Part - II
